February 24, 2014

Europe has been at this crossroads before. An ancient multi-national empire creaks dangerously under the strains of modern nationalism and separatism. Its rulers fear the mob, and fast-moving events. It fears especially the example of a neighbouring independent state, once its colony. Above all, it fears the future.

A century ago this was the Austro-Hungarian Empire, where the Hohenzollern dynasty, ruling in Vienna, determined to crush the rising challenge of Serbian nationalism. In planning war on Serbia, the Austrian government knew that Serbia had a powerful ally, Imperial Russia. The Austrians knew they would face strong resistance. They feared their enemies, but they feared the future more. They gambled on war.

Austria was encouraged in its war aims by the rising power of Germany, which expected to take advantage of the resulting conflict to settle accounts with its own rivals and shift the balance decisively in its own favour. This too was a gamble.

Today the ancient, creaking multi-national empire is Russia itself, where the Kremlin looks to events in the neighbouring Ukraine, once ruled from Moscow, with mounting anxiety.

Note what I am not saying. I'm not saying that history repeats itself. It doesn't repeat itself at all, never mind exactly one hundred years later. Over a century the world has changed in too many ways for this to be a nice laboratory experiment with controlled conditions under which similar reagents reliably produce a similar result. All that history can tell us is some of the risks in the situation -- and not all of them, because there is always something latent or new that did not happen before.

But I am saying that Europe is at a dangerous crossroads. A popular uprising has rid Kiev of the corrupt Yanukovych regime. In this moment, 45 million Ukrainians face an unknown future. That's their problem. It's not an easy problem. If it had been easy, former president Yushchenko and former PM Tymoshenko would have solved their first time around, in 2005. They would not have fallen out and Yanukovych would not have been elected president in 2010.

The one thing that Ukrainians cannot change is their location. Russia was, is, and will remain their powerful neighbour. Many Ukrainians speak Russian and feel Russian. Whether the reformers like it or not, they have to take this into account.

The problem for Russia's president Putin begins with the fact that events in Kiev look set to put an end to his dream of uniting Ukraine with Russia and Belarus in a Eurasian Union. Worse than that, Ukraine in this moment embodies an existential threat to his rule. If the people can get rid of Yanukovych, they can get rid of Putin.

The problem for 700 million Europeans in this moment is: What will Russia do now? Does Russia have the will and the capability intervene in Ukraine by whatever means present themselves -- openly or under cover, by inducements, threats, or force? Financial inducements have been tried. Repression from within has been tried. Both have failed. What else can Russia do?

When rulers feel their survival is at stake, the normal restraints and inhibitions can melt away. They may not act rashly or precipitately; they will still calculate and if calculation suggests waiting they will wait. But what enters the calculation and with what weight may change. And pessimism is a dangerous element, because fear of the future may tilt the calculation in favour of taking a gamble on precipitate action today.

If the alternative is to be chased out of the presidential palace, the resort to violence may no longer look so bad. That's what Yanukovych showed us last week. I wonder what Putin is thinking about this morning.

July 16, 2013

On Pieria, John Aziz writes in defence of protectionism, that is, the use of taxes and subsidies to shield a country's economy from foreign competition. He begins from the Ricardian story of the benefits of two countries sharing the benefits of free trade based on comparative advantage.

England was good at producing wool, Portugal wine, so they trade and both are better off. There is the fairy tale about how because market transactions are always voluntary and always beneficial that trade, being simply a market transaction across borders, is always win-win.

But this, he says, is a "fairy tale." In real life, he argues, comparative advantage has little to do with resource endowments and is generally artificial. Comparative advantage may be part of the historical pattern, he concedes. But it misses something essential. What's missing? He goes on.

Let's imagine a model with two different goods, say, guns and butter. England specialises in producing guns and munitions, and Portugal in butter and agricultural produce. For years, they trade and enjoy the benefit of maximising output through specialisation. Then, England starts a trade dispute with Portugal. They cease trading. England loses access to butter and various agricultural products from Portugal's large population of butter-producing cows, having to replace Portuguese butter with lower-quality and higher-priced Welsh butter. Portugal, however, loses access to guns and munitions. Although this is immediately recognised as a risk to national security, and Portugal quickly tries to start up its own domestic firearms industry, the trade dispute escalates into full-blown war and with their geostrategic advantage in guns, England swiftly triumphs and occupies Portugal.

The implication is clear. Portugal should have insured itself against the contingency of conflict with England by limiting trade through protectionism. By means of an interventionist industrial policy, Portugal would have developed its own guns and could then have resisted England.

Several things are noteworthy about this argument.

First, it too is a fairy tale. As John Aziz rightly points out, there's nothing intrinsically wrong with that. All our models are fairy tales. The point is that some are useful and others not. How can we tell? We test them against stuff that has actually happened. If they survive the confrontation, then we can use them to suggest practical implications for the future. So, the fact that it's a fairy tale is of interest, but it's not a problem. Let's move on.

Next noteworthy point: Let's test this model against something that actually happened. Not literally, because England has not been to war with Portugal since long before gunpowder came along. Replace Portugal by Germany, however, and the fairy tale suddenly acquires an ominous ring of truth. Doesn't it have an uncanny fit with what happened in 1914?

No, not exactly. In 1914 Germany and Britain went to war. While Britain was the pioneer of free trade, Germany had practised protectionism since 1879. German tariffs limited trade and promoted self-sufficiency in both industrial and agricultural goods. In Britain, by contrast, free trade accelerated the decline of agriculture and maximized the exposure of the British economy to imports. In 1913 at least 60 percent of the calories used at home for human consumption were imported. Many observers thought that left Britain ridiculously vulnerable to wartime blockade. German naval strategists agreed. It's true that in World War I food became a weapon of war just as much as guns.

Yet in the outcome it was Germany, the protectionist power, that struggled to manage the wartime disruption of trade and saw civilians die of hunger, while the British got by without serious shortages.

What explains this turnaround? As Mançur Olson (1963) argued (and before him Friedrich Aeroboe), the German economy entered the war in 1914 already weakened by protectionism. Food tariffs had encouraged peasant farmers to stay on their farms. This kept a large subsistence agriculture in being and reduced productivity and incomes. Because German farmers were already well into diminishing returns it was then hard to increase output at need, when war broke out.

As for industry, because imports of food into Germany were restricted in peacetime and labour held back in agriculture, German urban employers faced higher wage costs. To compensate for higher wage costs, industrial firms economized on labour and pushed up productivity. But across the economy as a whole, efficiency and average incomes were reduced.

A history of protectionism gave no national advantage in either World War. I've argued (in several places; see Harrison 2012 for example) that the main factors that gave systematic advantage were a country's size and wealth, and the main source of disadvantage was a peasant-based agriculture.

In that case, what's protectionism all about? In understanding protectionism, redistribution is much more important than development. Whether tariffs and subsidies raise or lower long-run growth, in the short run they redistribute income away from consumers and exporters to import-competing firms, often by very large amounts. This should draw attention to their political significance. As Dani Rodrik (1995, p. 1470) once wrote:

Saying that trade policy exists because it serves to transfer income to favored groups is a bit like saying Sir Edmund Hillary climbed Mount Everest because he wanted to get some mountain air.

In history, protectionism has given politicians a powerful instrument to bind those "favored groups" into their projects. To Bismarck, protectionism was political: it brought together the interests of "iron and rye" to share rents and support Germany's "peaceful rise." Similar motivations lie behind most real-life experiments in protectionism that I am familiar with. The only real exception is the Soviet experience of autarkic industrialization; that was different because Stalin was an absolute dictator who ruled by fear and had no need to pay off campaign funders.

Modern promoters of the developmental state (including Dani Rodrik) could reply that they advocate only those selective interventions that are designed to improve social welfare, not corrupt the political process. That's an argument I understand, but it requires a benevolent, far-sighted government with the power to intervene and the self-restraint to do so only for the common good, not for the good of its supporters. That's a bit of a problem. I don't see a political system anywhere, short of totalitarian dictatorship, in which you could advance those policies and see them implemented without vested interests jumping on your bandwagon and hijacking it for their own purposes, which will have nothing to do with social welfare.

(It's ironic, then, that John Aziz lists "graft and corruption" as a problem of trade liberalization, because opportunities for corruption are created only where the government has something to withhold.)

The historical link between protectionism and aggressive nation building is strong. Using data for 1950 to 1992 Erik Gartzke (2007) has shown that restricting a country's trade and capital flows is a good predictor of its propensity to engage in conflict. From data for 1865 and 1914, Patrick McDonald and Kevin Sweeney (2007) have shown that protectionism was a robust precursor of engagement in "revisionist" wars.

John Aziz concludes with a warning:

China's monopoly on rare earth metals which have very many military applications may have national security implications for other nations including Britain and the United States whose ability to manufacture modern military equipment might be impeded by a trade breakdown.

Shouldn't we worry? Yes, but that's because we need to understand China, not because we should be preparing for war. Indeed, one of Mancur Olson's key conclusions was that it's a mistake to think of particular raw materials, and even oil or food, as in some way "strategic" or "essential." Only the final uses of resources are essential. In practice, if some particular material suddenly becomes scarce, the price goes up and and opportunities present themselves to economize at the margin or find alternative sources or substitutes.

The price goes up, it's true. In other words, the alternatives may be costly. But the richer you are, the more easily you can meet the cost. That's why rich countries survive trade disruption and win wars. As for protectionism, to the extent that it diverts resources from their best uses, it makes the country poorer in advance and so less able to afford the measures that might become necessary in a national emergency.

Which brings me to the last noteworthy point about the arguments that John Aziz makes: They have nothing to do with personal well being. As he correctly comments:

The relative value of outcomes is simply a matter of one's criteria.

In truth, the two fairy tales that he tells differ in addressing completely different criteria. The free-trade fairy tale always was and is about the personal welfare of all members of society. Here, society is global: when trade is free, all gain, not just the residents of one country. The protectionist fairy tale, in contrast, is about nation-building and facilitating conflict in a world where elite coalitions build states, states compete for power, and a gain for one country is a loss to others.

The world is a complicated place. In the same spirit as John Aziz when he notes that the free trade story has some merit, I'm going to accept that the unregulated interaction between real world economies sometimes creates losers. There have evidently been historical circumstances when protectionist policies accidentally did no harm, or even did good by accidentally correcting some market failure.

But the design of protectionism has generally been far more driven by vested interests and power building than by concern for social welfare. Those who enter themselves in the reckoning against free trade often rely on an idealized understanding of the record.

March 10, 2013

China’s territorial claims and bellicose actions in the Western Pacific have aroused concerns about where this process could lead. In The Shadow of 1914 falls over the Pacific (in the Financial Times on 4 February), Gideon Rachman asked whether we are watching a re-run of events that led to the outbreak of World War I in 1914.

Then, a rising power (Germany) was challenging the established power (Britain) for a say in world affairs and a share in the world's colonial territories. It was not Germany's plan to make war on Britain; German leaders wanted only a say and a share. The economic, military, and naval power that they built was not made to go to war, only to prevent Britain from blocking Germany’s demands. They wanted to ensure peace and to command respect. The war that then came about was not meant to happen. The war would not have happened at all if allies, agents, proxies, and third parties beyond their control had not helped to bring it about.

Replace Britain by the United States, Germany by China, and Austria-Hungary, Russia, and Serbia by Japan, Vietnam, and North and South Korea, and you have Rachman's story in a nutshell. Rachman's conclusion is hopeful, however: China's leaders have tried to learn from history. That, and the inhibitions added by nuclear weapons, will help to avert war.

What was the role of calculation in the outbreak of World War I? Rachman writes as though the war was not calculated at all:

Leaders on all sides felt helpless as they were swept towards a war that most of them did not want.

But something is missing here. While the war was in some sense unwanted, the leaders were not helpless: they chose war. It was a calculated decision, and it was not a miscalculation: those who favoured war correctly estimated that victory was far from certain. They had a war plan for a quick victory over France that relied on a high speed military manoeuvre on a colossal scale, a decision by Britain to abstain, and a Russian mobilization that would obligingly wait until the German Army was ready to switch its focus from West to East. They knew it was an outrageous gamble.

Critical to this story was something that I will call rational pessimism. By 1912, Germany no longer felt itself the confident, rising power once led by Bismarck. Germany’s leaders had come to fear the future. Their own attempts to secure Germany’s rightful place in the sun, they feared, were leaving Germany ever weaker.

These fears were well founded. Externally, the balance of power was tilting away from Germany. More countries were adhering to the anti-German alliance of Britain and France. Britain and Russia were rearming at a pace that nullified Germanys’ own efforts. Given time, Germany would only become weaker. Within Germany the balance was tilting away from monarchism and conservatism towards parliamentary socialism. The fiscal demands of rearmament were opening up new social divisions. Germany’s Prussian bureaucracy and aristocracy felt itself more and more besieged.

Increasingly the calculation became: If we fight, we may lose but at least there is a chance that we win. If we remain at peace, we certainly lose. From this point of view the war was a gamble, but it was not a miscalculation. It was simply the choice with the highest expected value. For this reason the leaders of the Central Powers went to war full of foreboding, but they went to war anyway.

Russia’s military power growing fast … Austria grows ever weaker … This time things are worse than 1912, because now Austria is on the defensive against the Serb-Russian agitation. … The future belongs to Russia, which grows and grows into an ever great weight pressing down on our chest.

The chancellor is very pessimistic about Germany’s intellectual condition. Frightful decline of our political niveau. Individuals are becoming ever smaller and more insignificant; nobody says anything great and honest. Failure of the intelligentsia and of the professors.

This pessimism was general. When Germany’s Wilhelm II was informed of the Austrian ultimatum to Serbia, he wrote:

Now or never.

In Vienna, Kaiser Franz-Josef wrote:

If we go under, we better go under decently.

(The latter quotes are from Holger Herwig’s The First World War: Germany and Austria-Hungary, 1914-1918, published in 1997 by Arnold).)

From this perspective it becomes crystal clear why North Korea’s predicament is so dangerous. Day by day, North Korea is provoking enemies and losing friends. The tensions within the country are largely unknown but surely increasing. What insider would predict a peaceful future for the Pyongyang regime that is better than today? What does Kim Jong-Un have left to lose from gambling on conflict, no matter how poor the odds? Rational pessimism is surely tilting North Korea’s choices towards war. Still, we are not there yet.

As for China itself, the threat of war should be thought of as one for the future. It seems unlikely that China’s leaders would ever choose to gamble everything on a major war as long as they expect to gain more from a continuation of peace. Their optimism is a bulwark against war.

The risk is that optimism is fragile. China faces many problems that could sap the confidence of its leadership. Edward Luttwak (in The Rise of China vs the Logic of Strategy, published in 2012 by the Belknap Press of Harvard University) has written that China is pursuing an impossible trinity of prosperity, diplomatic influence, and military power. China’s economic growth may falter. Even if economic growth is sustained in China, the chances are that at some stage the West will recover its prosperity and technological leadership. Meanwhile China’s rearmament and territorial claims are losing it friends in Japan, Vietnam, and India. At home, there are protests over a range of issues that widens continually: the rule of law, corruption, censorship, inequality, wages and working conditions, land grabs, and pollution. China’s rulers rely on xenophobia and stories of foreign encirclement and penetration to manage these threats to their legitimacy.

Putting all this together, it is not hard to envisage a future in which China’s leaders would become rational pessimists. Would they then be held back by knowledge of history and by the possibility of nuclear war? Maybe. Is Kim Jong-Un restrained by these things today? So far, yes. If Germany’s rulers in 1914 could have seen the future, would they have chosen differently? Perhaps. Unfortunately, we can’t be sure.

I am a professor in the Department of Economics at the University of Warwick. I am also a research associate of Warwick’s Centre on Competitive Advantage in the Global Economy, and of the Centre for Russian, European, and Eurasian Studies at the University of Birmingham. My research is on Russian and international economic history; I am interested in economic aspects of bureaucracy, dictatorship, defence, and warfare. My most recent book is One Day We Will Live Without Fear: Everyday Lives Under the Soviet Police State (Hoover Institution Press, 2016).